Want an investment that will mirror the performance of a market index you feel has long-term growth potential?

You might consider exchange-traded funds (ETFs).

ETFs are basically exchange-traded mutual funds that hold assets such as stocks, commodities, bonds and currencies.

They trade just like a stock and try to track the performance of a specific market index by holding the same assets as that index or by holding a representative sample of those assets.

ETFs have low fees

If you hold an ETF that tracks the Dow Jones Industrial Average and the Dow has a strong year, so will your ETF. But if your investment follows an index that loses value, you will suffer a similar loss.

They’re still relatively new products — first arriving on the investment scene about 20 years ago — but many investors have embraced them wholeheartedly.

Globally, investors piled $265 billion into ETFs last year, up from $170 billion in 2011. ETF assets held by Canadians grew by about 30 per cent last year to $56.4 billion.

About 16 per cent of the trading volume on the New York Stock Exchange last year was in ETFs.

But according to the Investment Funds Institute of Canada, just 31 per cent of Canadian investors surveyed last year expressed confidence in ETFs as an investment product — compared with 80 per cent who were confident in mutual funds, 59 per cent who were confident in bonds and 57 per cent who expressed confidence in stocks.

Jonathon Palfrey, senior vice-president at Leith Wheeler Investment Counsel, said there are thousands of different ETFs available now and that overwhelming selection can confuse some consumers.

“Too many products came along and it became too complex for the average do-it-yourself investor — sometimes involving risky investments with more costs than people expected,” he said.

The vast majority of ETFs are “passive” investments structured to mirror an index, which keeps fees low because there are no research or service costs and they are not managed by a fund manager on a daily basis. The average fee associated with such an ETF is about 0.7 per cent of the fund’s value, compared with average mutual fund fees of about two per cent.

Leith Wheeler vice-president Karey Irwin noted that passive ETFs expose you to a specific market, so you’ll get the good and bad of whatever happens to that market.

“The ETF is never going to perform as well as the market,” she said. “It’s always going to perform a little worse because of the fee (that will reduce any gain or increase any loss).”

‘Active’ ETFs more costly

A small portion of ETFs are “active” investments with fund managers who create their own basket of assets to try to beat the annual performances of market indexes.

There can be significant fees associated with active ETFs and Irwin said they are probably best suited for more sophisticated investors who don’t mind the greater risk/reward that might be associated with an active ETF.

“There may be way more risk with an active ETF if it uses leverage,” she said. “They can be fairly expensive as there are different levels of fees that can be added on. They all have management fees and some have service fees and a performance fee, which can take away some of the growth.”

Palfrey said ETFs can be accessible to average investors — with the cost of entry being as little as a few hundred dollars — and they can offer diversification benefits for investors who may own just a few stocks or bonds.

Many investors also like the stock-like features of an ETF. While mutual funds can only be bought or sold at the end of a trading day, ETFs can be traded whenever markets are open so investors can use stock trading strategies such as selling short and buying on margin.

Irwin warned the active trading that can be associated with ETFs isn’t always a good thing.

“We’ve seen investor behaviour when markets are volatile — it’s not always good long-term behaviour,” she said. “People can hurt themselves if they’re really active through the trading day and it magnifies the fear when things are bad.”

Questions to ask

Passive ETFs generally assess low fees but active trading of ETF shares can cause investor costs to rise. While transaction fees on mutual funds vary, you have to pay a commission every time you trade an ETF share on an exchange.

“It doesn’t sound that bad in a discount world where it only costs $9.99 a trade but it can add up,” Palfrey said.

He said it’s crucial for investors to do their homework before investing in any ETF, answering questions such as:

• Are you investing in something with a proven track record over a market cycle of seven to 10 years or at least five years?

• Does it have the same people in place and same sound strategy to do well in the future, or is it just chasing the flavour of the month, a fad or something that did well last year?

“They can just pop up and mimic some certain style of a star economist or pundit and they don’t have proven success,” Palfrey said. “They just kind of come to market, get assets and then close because they have been bad ideas.”

There were 12 ETF closures in Canada last year, with most shutting down because they couldn’t generate enough revenue to cover the fund’s operating costs.

Palfrey feels marketing and advertising have clearly helped the growth of ETF sales in Canada, along with the growth of do-it-yourself investors who feel ETFs are a good vehicle to help them cut costs and be in control.

“It can also work as a blend to have a portion of your money in a passive ETF while having the other portion in actively managed funds that charge higher fees,” he said.